On September 27, 2010, Southwest Airlines announced that it

Transcription

1 Cash Flows and Capital Budgeting 11 Learning Objectives 1 Explain why incremental after-tax free cash flows are relevant in evaluating a project and calculate them for a project. 2 Discuss the five general rules for incremental after-tax free cash flow calculations and explain David Woo/ Corbis why cash flows stated in nominal (real) dollars should be discounted using a nominal (real) discount rate. On September 27, 2010, Southwest Airlines announced that it 3 Describe how distinguishing between variable and fixed costs can be useful in fore- had agreed to purchase its smaller rival AirTran Airways for $1.4 billion in cash and stock. This would be the third large U.S. airline merger in two years. By the end of the day, Southwest s stock casting operating expenses. price was up 8.7 percent while the S&P 500 stock market index was down 0.5 percent. The 8.7 percent change in Southwest s stock price represented a nearly $800 million increase in the total value of its common stock. This increase, combined with the decrease in the value of the S&P 500 index, suggests that investors thought the acquisition of AirTran would have a very large positive impact on the wealth of Southwest stockholders. When the managers of Southwest announced their plans to acquire AirTran, they were announcing a $1.4 billion investment. This investment was viewed by stock market investors from the same 4 5 Explain the concept of equivalent annual cost and use it to compare projects with unequal lives, decide when to replace an existing asset, and calculate the opportunity cost of using an existing asset. Determine the appropriate time to harvest an asset. perspective as any capital project that a firm might pursue. Investors evaluated whether the Net Present Value (NPV) of the expected cash flows from the acquisition of AirTran would be positive or negative. The financial model used to estimate this NPV is the same one you saw in Chapter 10. The increase in the value of Southwest stock on the day of the announcement reflected investors estimates of the NPV of the decision to purchase Airtran. CHAPTER ELEVEN

2 42 CHAPTER 11 I Cash Flows and Capital Budgeting In Chapter 10 we stressed understanding the NPV concept and other project valuation models as well as the mechanics of discounting project cash flows. This chapter focuses on what project cash flows are discounted and how they are calculated and used in practice. The topics covered in this chapter are central to the goal of value creation. It is necessary to understand them in order to determine which capital projects have positive NPVs and which projects have negative NPVs. Only if you can do this will you be able to choose projects that create value. CHAPTER PREVIEW In Chapter 10 we saw that capital budgeting involves comparing the benefits and costs associated with a project to determine whether the project creates value for stockholders. These benefits and costs are reflected in the cash flows that the project is expected to produce. The NPV is a dollar measure of the amount by which the present value of the benefits exceeds the present value of the costs. Chapters 11 through 13 discuss how analysts actually apply the concepts introduced in Chapter 10 in capital budgeting. This chapter and Chapter 12 focus on cash flows, while Chapter 13 covers concepts related to the discount rate. The major focus of this chapter is on the cash flows from a project. We begin with a discussion of how to calculate the cash flows used to compute the NPV of a project. We then present five rules to follow when you calculate cash flows. We also address some concepts that will help you better understand cash flow calculations. Next, we discuss how analysts actually forecast a project s cash flows. Since the cash flows generated by a project will almost certainly differ from the forecasts, it is important to have a framework that helps minimize errors and ensures that forecasts are internally consistent. We discuss such a framework in this part of the chapter. In the last section, we examine some special cases that arise in capital budgeting problems. For example, we describe how to choose between two projects that have different lives, how to determine when an existing piece of equipment should be replaced, how to determine the cost of using excess capacity for a project, and when to harvest (or sell) an asset. 1.1 CALCULATING PROJECT CASH FLOWS LEARNING OBJECTIVE We begin our discussion of cash flows in capital budgeting by describing the mechanics of cash flow calculations and the rules for estimating the cash flows for individual projects. You will see that the approach we use to calculate project cash flows is similar to that used to calculate the cash flow to investors discussed in Chapter 3. However, there are two very important differences: BUILDING INTUITION 1. Most important, the cash flows used in capital budgeting calculations are based on forecasts of future cash revenues, expenses, taxes, and investment outlays. In contrast, in Chapter 3 CAPITAL BUDGETING IS FORWARD LOOKING In capital budgeting, we estimate the NPV of the cash flows that a project is expected to produce in the future. In other words, all of the cash flow estimates are forward looking. This is very different from using historical accounting statements to estimate cash flows. we focused on calculating cash flows to investors using accounting statements, which reflect historical performance rather than the future cash flows that might be generated by the firm and its projects. 2. In capital budgeting we focus on estimating the cash flows we expect an individual project to produce in the future, which we refer to as incremental after-tax free cash flows. In contrast, the cash flow to investors in Chapter 3 is a measure of the cash flows

3 11.1 Calculating Project Cash Flows 343 Incremental After-Tax Free Cash Flows The cash flows we discount in an NPV analysis are the incremental after-tax free cash flows that are expected from the project. The term incremental refers to the fact that these cash flows reflect how much the firm s total after-tax free cash flows will change if the project is adopted. Thus, we define the incremental after-tax free cash flows (FCF) for a project as the total aftertax free cash flows the firm would produce with the project, less the total after-tax free cash flows the firm would produce without the project. FCF Project FCF Firm with project FCF Firm without project (11.1) In other words, FCF Project equals the net effect the project will have on the firm s cash revenues, costs, taxes, and investment outlays. These are the cash flows investors care about. Throughout the rest of this chapter, we will refer to the total incremental after-tax free cash flows associated with a project simply as the FCF for the project. For convenience, we will drop the Project subscript from the FCF in Equation The FCF for a project is what we generically referred to as NCF in Chapter 10. The term free cash flows, which is commonly used in practice, refers to the fact that the firm is free to distribute these cash flows to creditors and stockholders because these are the cash flows that are left over after a firm has made necessary investments in working capital and long-term assets. The cash flows associated with financing a project (cash outflows or inflows to or from creditors or stockholders) are not included in the FCF calculation because, as we will discuss in Chapter 13, these are accounted for in the discount rate that is used in an NPV analysis. All of these points will become clearer as we discuss the FCF calculation next. The FCF Calculation The FCF calculation is illustrated in Exhibit Let s begin with an overall review of how the calculation is done. After that, we will look more closely at details of the calculation. When we calculate the FCFs for a project, we first compute the incremental cash flow from operations (CF Opns) for each year during the project s life. This is the cash flow that the project is expected to generate after all operating expenses and taxes have been paid. To obtain the FCF, we then subtract the incremental capital expenditures (Cap Exp) and the incremental additions to working capital (Add WC) required for the project. Cap Exp and Add WC represent the investments in long-term assets, such as property, plant, and equipment, and in working capital items, such as accounts receivable, inventory, and accounts payable, which must be made if the project is pursued. EXHIBIT 11.1 The Free Cash Flow Calculation This exhibit shows how the incremental after-tax free cash flow (FCF) for a project is calculated. The FCF equals the change in the firm s cash income, excluding interest expense, that the project is responsible for, plus depreciation and amortization for the project, minus all required capital expenditures and investments in working capital. FCF also equals the incremental after-tax cash flow from operations minus the capital expenditures and investments in working capital required for the project. Explanation Calculation Formula The change in the firm s cash income, excluding interest expense, resulting from the project. Adjustments for the impact of depreciation and amortization and investments on FCF. Revenue Cash operating expenses Earnings before interest, taxes, depreciation, and amortization Depreciation and amortization Operating profit Revenue Op Ex EBITDA D&A EBIT (1 Firm s marginal tax rate) (1 t) Net operating profit after tax NOPAT Depreciation and amortization D&A Cash flow from operations CF Opns Capital expenditures Cap Exp Additions to working capital Add WC incremental after-tax free cash flows the difference between the total after-tax free cash flows at a firm with a project and the total after-tax free cash flows at the same firm without that project; a measure of a project s total impact on the free cash flows at a firm incremental cash flow from operations (CF Opns) the cash flow that a project generates after all operating expenses and taxes have been paid but before any cash outflows for investments incremental capital expenditures (Cap Exp) the investments in property, plant, and equipment and other long-term assets that must be made if a project is pursued incremental additions to working capital (Add WC) the investments in working capital items, such as accounts receivable, inventory, and accounts payable, that must be made if the project is pursued

4 44 CHAPTER 11 I Cash Flows and Capital Budgeting BUILDING INTUITION cremental depreciation nd amortization (D&A) e depreciation and mortization charges that are ssociated with a project rm s marginal tax rate (t) e tax rate that is applied each additional dollar of arnings at a firm and-alone principle e principle that allows us to eat each project as a standlone firm when we perform n NPV analysis As we noted earlier, the calculation of free cash flows for capital budgeting, which is summarized in Exhibit 11.1, is very similar to the calculation of the cash flows to investors that we discussed in Chapter 3. This should not be surprising since managers evaluate projects based on the present value of the cash flows they produce for their firms investors. Nevertheless, there is an important computational difference between the cash flow calculations in Chapters 3 and 11. In Exhibit 11.1 the taxes for a project analysis are computed by multiplying the project s operating profit (EBIT) by the firm s marginal tax rate. This calculation gives us the taxes that the firm would owe on a project if no debt is used to finance that project. In contrast, the calculation in Chapter 3 uses the actual taxes paid by the firm, which includes the effect that interest deductions have on the taxes owed. It is true that interest payments will reduce the taxable income from a project if any debt financing is used. However, we ignore this reduction when evaluating a project for two reasons. First, we want to exclude the effects associated with how the project is financed in order to isolate the cash flows from the project itself. Second, as we discuss in Chapter 13, the cost of both debt and equity financing for a project are reflected in the discount rate. Doing the calculation this way makes it easier to estimate the NPV of a project under alternative financial structures. Since the FCF calculation gives us the after-tax cash flows from operations over and above what is necessary to make any required investments, the FCFs for a project are the cash flows that the firm s investors can expect to receive from the project. This is why we discount the FCFs when we compute the NPV. The formula for the FCF calculation can also be written as: INCREMENTAL AFTER-TAX FREE CASH FLOWS ARE WHAT STOCKHOLDERS CARE ABOUT IN CAPITAL BUDGETING When evaluating a project, managers focus on the FCF that the project is expected to produce because that is what stockholders care about. The FCFs reflect the impact of the project on the firm s overall cash flows. They also represent the additional cash flows that can be distributed to security holders if the project is accepted. Only after-tax cash flows matter because these are the cash flows that are actually available for distribution after taxes are paid to the government. FCF 31Revenue Op Ex D&A2 11 t24 D&A Cap Exp Add WC (11.2) where Revenue is the incremental revenue (net sales) associated with the project, D&A is the incremental depreciation and amortization associated with the project, and t is the firm s marginal tax rate. Let s use Equation 11.2 to work through an example. Suppose you are considering purchasing a new truck for your plumbing business. This truck will increase revenues $50,000 and operating expenses $30,000 in the next year. Depreciation and amortization charges for the truck will equal $10,000 next year, and your firm s marginal tax rate will be 35 percent. Capital expenditures of $3,000 will be required to offset wear and tear on the truck, but no additions to working capital will be required. To calculate the FCF for the project in the next year, you can simply substitute the appropriate values into Equation 11.2: FCF 31Revenue Op Ex D&A2 11 t24 D&A Cap Exp Add WC 31$50,000 $30,000 $10, $10,000 $3,000 $0 $13,500 The FCF calculated with Equation 11.2 equals the total annual cash flow the firm will produce with the project less the total cash flow the firm will produce without the project. Even so, it is important to note that it is not necessary to actually estimate the firm s total cash flows in an NPV analysis. We need only estimate the cash outflows and inflows that arise as a direct result of the project in order to value it. The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as the stand-alone principle. The stand-alone principle says that we can treat the project as if it were a stand-alone firm that has its own revenue, expenses, and investment requirements. NPV analysis compares the present value of the FCF from this stand-alone firm with the cost of the project. To fully understand the stand-alone principle, it is helpful to consider an example. Suppose that you own shares of stock in Dell, Inc., and that Dell s stock is currently selling for $ Now suppose that Dell s management announces it will immediately invest $1.9 billion in a new production and distribution center that is expected to produce after-tax cash flows of $0.6 billion per year forever. Since Dell has 1.9 billion shares outstanding and uses

5 11.1 Calculating Project Cash Flows 345 shares = $1.00 per share). The annual increase in the cash flows for Dell is expected to be $0.32 per share per year ($0.6 billion/1.9 billion shares = $0.32 per share). How should this announcement affect the value of a share of Dell stock? If the appropriate cost of capital for the project is 10 percent, then from Equation 9.2 and the discussion in Chapter 10, we know that the value of a share of Dell s stocks should increase by D/R $0.32/0.10 $3.20 less the $1.00 invested, or $2.20, making each share of Dell stock worth $13.90 $2.20 $16.10 after the announcement. This example illustrates how the stand-alone principle allows us to simply add the value of a project s cash flows to the value of the firm s other cash flows to obtain the total value of the firm with the project. Cash Flows from Operations Let s examine Exhibit 11.1 in more detail to better understand why FCF is calculated as it is. First, note that the incremental cash flow from operations, CF Opns, equals the incremental net operating profits after tax (NOPAT) plus D&A. If you refer back to the discussion of the income statement in Chapter 3, you will notice that NOPAT is essentially a cash flow measure of the incremental net income from the project without interest expenses. In other words, it is the impact of the project on the firm s cash flow, excluding the effects of any interest expenses associated with financing the project. We exclude interest expenses when calculating NOPAT because, as we mentioned earlier, the cost of financing a project is reflected in the discount rate. We use the firm s marginal tax rate, t, to calculate NOPAT because the profits from a project are assumed to be incremental to the firm. Since the firm already pays taxes, the appropriate tax rate for FCF calculations is the tax rate that the firm will pay on any additional profits that are earned because the project is adopted. You may recall from Chapter 3 that this rate is the marginal tax rate. We will discuss taxes in more detail later in this chapter. We add incremental depreciation and amortization, D&A, to NOPAT when calculating CF Opns because, as in the accounting statement of cash flows, D&A represents a noncash charge that reduces the firm s tax obligation. Note that we subtract D&A before computing the taxes that the firm would pay on the incremental earnings for the project. This accounts for the ability of the firm to deduct D&A when computing taxes. However, since D&A is a noncash charge, we have to add it back to NOPAT in order to get the cash flow from operations right. The net effect of subtracting D&A, computing the taxes, and then adding D&A back is to reduce the taxes attributable to earnings from the project. For example, suppose that EBITDA for a project is $100.00, D&A is $50.00, and t is 35 percent. If we did not subtract D&A before computing taxes and add it back to compute CF Opns, the taxes owed for the project would be $ $35.00 and CF Opns would be $ $35.00 $ This would understate CF Opns from this project by $17.50 since deducting D&A reduces the firm s tax obligation by this amount. With this deduction, the correct tax obligation is ($ $50.00) 0.35 $17.50 and the correct CF Opns is $ $17.50 $ We get exactly this value when we compute CF Opns as shown in Exhibit 11.1 and Equation 11.2: CF Opns 31Revenue Op Ex D&A2 11 t24 D&A since Revenue Op Ex EBITDA, as shown in Exhibit 11.1, we can write: CF Opns 31EBITDA D&A2 11 t24 D&A 31$ $ $50.00 $82.50 Cash Flows Associated with Capital Expenditures and Net Working Capital Once we have estimated CF Opns, we simply subtract cash flows associated with the required investments to obtain the FCF for a project in a particular period. Investments can be required to purchase long-term tangible assets, such as property, plant, and equipment, to purchase intangible assets, such as patents, mailing lists, or brand names, or to fund current assets, incremental net operating profits after tax (NOPAT) a measure of the impact of a project on the firm s cash net income, excluding the effects of any interest expenses associated with financing the project tangible assets physical assets such as property, plant, and equipment intangible assets nonphysical assets such as patents, mailing lists, or brand names current assets assets, such as accounts receivable and inventories, that are expected to be liquidated (collected or sold)

6 46 CHAPTER 11 I Cash Flows and Capital Budgeting It is important to recognize that all investments that are incremental to a project must be accounted for. The most obvious investments are those in the land, buildings, and machinery and equipment that are acquired for the project. However, investments in intangible assets can also be required. For example, a manufacturing firm may purchase the right to use a particular production technology. Incremental investments in long-term tangible assets and intangible assets are collectively referred to as incremental capital expenditures (Cap Exp). In addition to tangible and intangible assets, such as those described earlier, it is also necessary to account for incremental additions to working capital (Add WC). For example, if the product being produced is going to be sold on credit, thereby generating additional accounts receivable, the cost of providing that credit must be accounted for. Similarly, if it will be necessary to hold product in inventory, the cost of financing that inventory must be considered. Finally, it is important to consider any incremental changes in current liabilities associated with the project. The FCF Calculation: An Example Let s work a more comprehensive example to see how FCF is calculated in practice. Suppose that you work at an outdoor performing arts center and are evaluating a project to increase the number of seats by building four new box seating areas and adding 5,000 seats for the general public. Each box seating area is expected to generate $400,000 in incremental annual revenue, while each of the new seats for the general public will generate $2,500 in incremental annual revenue. The incremental expenses associated with the new boxes and seating will amount to 60 percent of the revenues. These expenses include hiring additional personnel to handle concessions, ushering, and security. The new construction will cost $10 million and will be fully depreciated (to a value of zero dollars) on a straight-line basis over the 10-year life of the project. The center will have to invest $1 million in additional working capital immediately, but the project will not require any other working capital investments during its life. This working capital will be recovered in the last year of the project. The center s marginal tax rate is 30 percent. What are the incremental cash flows from this project? When evaluating a project, it is generally helpful to first organize your calculations by setting up a worksheet such as the one illustrated in Exhibit A worksheet like this helps ensure that the calculations are completed correctly. The left-hand column in Exhibit 11.2 shows the actual calculations that will be performed. Other columns are included for each of the years during the life of the project, from year 0 (today) through the last year in the life of the project (year 10). In this example the cash flows will be exactly the same for years 1 through 9; therefore, for illustration purposes, we will only include a single column to represent these years. If you were using a spreadsheet program, you would normally include one column for each year. EXHIBIT 11.2 FCF Calculation Worksheet for the Performing Arts Center Project A free cash flow (FCF) calculation table is useful in evaluating a project. It helps organize the calculations and ensure that they are completed correctly. Year 0 Years 1 to 9 Year 10 Revenue Op Ex EBITDA D&A EBIT (1 t) NOPAT D&A CF Opns Cap Exp Add WC FCF

7 Unless there is information to the contrary, we can assume that the investment outlay for this project will be made today (year 0). We do this because in a typical project, no revenue will be generated and no expenses will be incurred until after the investment has been made. Consequently, the only cash flows in year 0 are those for new construction (Cap Exp $10,000,000) and additional working capital (Add WC $1,000,000). The FCF in year 0 will therefore equal $11,000,000. In years 1 through 9, incremental revenue (Revenue) will equal: Box seating ($400,000 4) $ 1,600,000 Public seating ($2,500 5,000) $12,500,000 Total incremental net revenue $14,100,000 Incremental Op Ex will equal 0.60 $14,100,000 $8,460,000. Finally, depreciation (there is no amortization in this example) is computed as: D&A 1Cap Exp Salvage value of Cap Exp2/Depreciable life of the investment 1$10,000,000 $02/10 years $1,000,000 Note that only the Cap Exp are depreciated and that these capital expenditures will be completely depreciated or written off over the 10-year life of the project because no salvage value is anticipated. Working capital is not depreciated because it will be recovered at the end of the project as the project s inventory is sold off, receivables are collected, and short-term liabilities are repaid. The cash flows in year 10 will be the same as those in years 1 through 9 except that the $1 million invested in additional working capital will be recovered in the last year. The $1 million is added back to (or a negative number is subtracted from) the incremental cash flows from operations in the calculation of the year 10 cash flows. The completed cash flow calculation worksheet for this example is presented in Exhibit We could have completed the calculations without the worksheet. However, as mentioned, a cash flow calculation worksheet is a useful tool because it helps us make sure we don t forget anything. Once we have set the worksheet up, calculating the incremental cash flows is simply a matter of filling in the blanks. As you will see in the following discussion, correctly filling in some blanks can be difficult at times, but the worksheet keeps us organized by reminding us which blanks have yet to be filled in. Notice that with a discount rate of 10 percent, the NPV of the cash flows in Exhibit 11.3 is $15,487,664. As in Chapter 10, the NPV is obtained by calculating the present values of all of the cash flows and adding them up. You might confirm this by doing this calculation yourself Calculating Project Cash Flows 347 EXHIBIT 11.3 Completed FCF Calculation Worksheet for the Performing Arts Center Project The completed calculation table shows how the incremental after-tax free cash flows (FCF) for the performing arts center project are computed, along with the NPV for that project when the cost of capital is 10 percent. Year 0 Years 1 to 9 Year 10 Revenue $14,100,000 $14,100,000 Op Ex 8,460,000 8,460,000 EBITDA $ 5,640,000 $ 5,640,000 D&A 1,000,000 1,000,000 EBIT $ 4,640,000 $ 4,640,000 (1 t) NOPAT $ 3,248,000 $ 3,248,000 D&A 1,000,000 1,000,000 CF Opns $ 4,248,000 $ 4,248,000 Cap Exp $10,000, Add WC 1,000, ,000,000 FCF $11,000,000 $ 4,248,000 $ 5,248,000 10% $15,487,664

8 48 CHAPTER 11 I Cash Flows and Capital Budgeting USING EXCEL PERFORMING ARTS CENTER PROJECT Cash flow calculations for capital budgeting problems are best set up and solved using a spreadsheet appli- cation. Here is the setup for the performing arts center project: The following is the formula setup for the performing arts center project. As we did in Exhibit 11.3, we have combined years 1 through 9 in a single column to save space. As mentioned in previous chapters, notice that none of the values in the actual worksheet are hard coded but instead use references from the key assumptions list, or specific formulas. This allows for an easy analysis of the impact of changes in the assumptions.

9 11.1 Calculating Project Cash Flows 349 FCF versus Accounting Earnings It is worth stressing again that the FCF we have been discussing in this section is what matters to investors. The impact of a project on a firm s overall value or on its stock price does not depend on how the project affects the company s accounting earnings. It depends only on how the project affects the company s FCF. Recall that accounting earnings can differ from cash flows for a number of reasons, making accounting earnings an unreliable measure of the costs and benefits of a project. For example, as soon as a firm sells a good or provides a service, its income statement will reflect the associated revenue and expenses, regardless of whether the customer has paid cash. Accounting earnings also reflect noncash charges, such as depreciation and amortization, which are intended to account for the costs associated with deterioration of the assets in a business as those assets are used. Depreciation and amortization rules can cause substantial differences between cash flows and reported income because the assets acquired for a project are generally depreciated over several years, even though the actual cash outflow for their acquisition typically takes place at the beginning of the project. Free Cash Flows SITUATION: You have saved $6,000 and plan to use $5,500 to buy a motorcycle. However, just before you go visit the motorcycle dealer, a friend of yours asks you to invest your $6,000 in a local pizza delivery business he is starting. Assuming he can raise the money, your friend has two alternatives regarding how to market the business. As illustrated below, both of these alternatives have an NPV of $2,614 with an opportunity cost of capital of 12 percent. You will receive all free cash flows from the business until you have recovered your $6,000 plus 12 percent interest. After that, you and your friend will split any additional cash proceeds. If you decide to invest, which alternative would you prefer that your friend choose? Alternative 1 Alternative 2 Year 0 Year 1 Year 2 Year 0 Year 1 Year 2 Revenue $12,000 $12,000 $16,000 $8,000 Op Ex 4,000 6,000 8,000 4,240 EBITDA $ 8,000 $ 6,000 $ 8,000 $3,760 D&A 2,500 2,500 2,500 2,500 EBIT $ 5,500 $ 3,500 $ 5,500 $1,260 (1 t) NOPAT $ 4,125 $ 2,625 $ 4,125 $ 945 D&A 2,500 2,500 2,500 2,500 CF Opns $ 6,625 $ 5,125 $ 6,625 $3,445 Cap Exp $5,000 2, $5, Add WC 1,000 (1,000) 1,000 (1,000) FCF $6,000 $ 4,625 $ 5,625 $6,000 $ 6,125 $3,945 NPV at 12% $2,614 $2,614 EXAMPLE 11.1 DECISION MAKING DECISION: If you expect no cash from other sources during the next year, you should insist that your friend choose alternative 2. This is the only alternative that will produce enough FCF next year to purchase the motorcycle. Alternative 1 will produce $6,625 in CF Opns but will require $2,000 in capital expenditures. You will not be able to take more than $4,625 from the business in year 1 under alternative 1 without leaving the business short of cash.

10 50 CHAPTER 11 I Cash Flows and Capital Budgeting > BEFORE YOU GO ON 1. Why do we care about incremental cash flows at the firm level when we evaluate a project? 2. Why is D&A first subtracted and then added back in FCF calculations? 3. What types of investments should be included in FCF calculations? 1.2 ESTIMATING CASH FLOWS IN PRACTICE LEARNING OBJECTIVE Now that we have discussed what FCFs are and how they are calculated, we are ready to focus on some important issues that arise when we estimate FCFs in practice. The first of these issues is determining which cash flows are incremental to the project and which are not. In this section we begin with a discussion of five general rules that help us do this. We then discuss why it is important to distinguish between nominal and real cash flows and to use one or the other consistently in our calculations. Next, we discuss some concepts regarding tax rates and depreciation that are crucial to the calculation of FCF in practice. Finally, we describe and illustrate special factors that must be considered when calculating FCF for the final year of a project. Five General Rules for Incremental After-Tax Free Cash Flow Calculations As discussed earlier, we must determine how a project would change the after-tax free cash flows of the firm in order to calculate its NPV. This is not always simple to do, especially in a large firm that has a complex accounting system and many other projects that are not independent of the project being considered. Fortunately, there are five rules that can help us isolate the FCFs specific to an individual project even under the most complicated circumstances. You can learn more about incremental free cash flows at Investopedia. com, investopedia.com. Rule 1: Include cash flows and only cash flows in your calculations. Do not include allocated costs unless they reflect cash flows. Examples of allocated costs are charges that accountants allocate to individual businesses to reflect their share of the corporate overhead (the costs associated with the senior managers of the firm, centralized accounting and finance functions, and so forth). To see how allocated costs can differ from actual costs (and cash flows), consider a firm with $3 million of annual corporate overhead expenses and two identical manufacturing plants. Each of these plants would typically be allocated one-half, or $1.5 million, of the corporate overhead when their accounting profitability is estimated. Suppose now that the firm is considering building a third plant that would be identical to the other two. If this plant is built, it will have no impact on the annual corporate overhead cash expense. Someone in accounting might argue that the new plant should be able to support its fair share of the $3 million overhead, or $1 million, and that this overhead should be included in the cash flow calculation. Of course, this person would be wrong. Since total corporate overhead costs will not change if the third plant is built, no overhead should be included when calculating the incremental FCFs for this plant. Rule 2: Include the impact of the project on cash flows from other product lines. If the product associated with a project is expected to affect sales of one or more other products at the firm, you must include the expected impact of the new project on the cash flows from the other products when computing the FCFs. For example, consider the analysis that analysts at Apple Inc. would have done before giving the go-ahead for the development of the iphone. Since, like the ipod, the iphone can store music, these analysts might have expected that the introduction of the iphone would reduce annual ipod sales. If so, they would have had to account for the reduction in cash flows from lost ipod sales when

11 Similarly, if a new product is expected to boost sales of another, complementary, product, then the increase in cash flows associated with the new sales from that complementary product line should also be reflected in the FCFs. For example, consider how the introduction of the Apple ipad might affect music and video downloads from Apple itunes. Many of the people who purchase an ipad and who have not previously downloaded songs and other content from itunes will begin to do so. The cash flows from downloads by these new users are not directly tied to ipad sales, but they are incremental to those sales. If Apple had not introduced the ipad device, it would not have these itunes sales. The analysis of the ipad project should have included the estimated impact of that project on cash flows from itunes. Rule 3: Include all opportunity costs. By opportunity costs, we mean the cost of giving up the next best opportunity. 1 Opportunity costs can arise in many different ways. For example, a project may require the use of a building or a piece of equipment that could otherwise be sold or leased to someone else. To the extent that selling or leasing the building or piece of equipment would generate additional cash flow for the firm and the opportunity to realize that cash flow must be forgone if the project is adopted, it represents an opportunity cost. To see why this is so, suppose that a project will require the use of a piece of equipment that the firm already has and that can be sold for $50,000 on the used-equipment market. If the project is accepted, the firm will lose the opportunity to sell the piece of equipment for $50,000. This is a $50,000 cost that must be included in the project analysis. Accepting the project reduces the amount of money that the firm can realize from selling excess equipment by this amount. Rule 4: Forget sunk costs. Sunk costs are costs that have already been incurred. All that matters when you evaluate a project at a particular point in time is how much you have to invest in the future and what you can expect to receive in return for that investment. Past investments are irrelevant. To see this, consider the situation in which your company has invested $10 million in a project that has not yet generated any cash inflows. Also assume that circumstances have changed so the project, which was originally expected to generate cash inflows with a present value of $20 million, is now expected to generate cash inflows with a value of only $2 million. To receive this $2 million, however, your company will have to invest another $1 million. Should your firm do it? Of course it should! The sunk cost for this investment is $10 million. Whether your company makes the incremental new investment or not, that money has been spent and is therefore not relevant for the decision about whether to invest $1 million now. Since the $1 million of new spending generates new cash flows worth $2 million, this is a project with a positive NPV of $1 million and it should be accepted. Another way to think about it is that if your company stops investing now, it will have lost $10 million. If it makes the investment, its total loss will be $9 million. Although neither is an attractive alternative, it should be clear that it is better to lose $9 million than it is to lose $10 million. The point here is that, while it is often painful to do, you should ignore sunk costs when computing project FCFs. Rule 5: Include only after-tax cash flows in the cash flow calculations. The incremental pretax earnings of a project matter only to the extent that they affect the after-tax cash flows that the firm s investors receive. For an individual project, as mentioned earlier, we compute the after-tax cash flows using the firm s marginal tax rate because this is the rate that will be applied against the incremental cash flows generated by the project. Let s use the performing arts center project to illustrate how these rules are applied in practice. Suppose the following requirements and costs are associated with this project: 1. The chief financial officer requires that each project be assessed 5 percent of the initial investment to account for costs associated with the accounting, marketing, and information technology departments Estimating Cash Flows in Practice The concept of opportunity cost here is similar to that discussed in Chapter 10, in the context of the opportunity cost

12 52 CHAPTER 11 I Cash Flows and Capital Budgeting 2. It is very likely that increasing the number of seats will reduce revenues next door at the cinema that your employer also owns. Attendance at the cinema is expected to be lower only when the performing arts center is staging a big event. The total impact is expected to be a reduction of $500,000 each year, before taxes, in the operating profits (EBIT) of the cinema. The depreciation of the cinema s assets will not be affected. 3. If the project is adopted, the new seating will be built in an area where exhibits have been placed in the past when the center has hosted guest lectures by well-known painters or sculptors. The performing arts center will no longer be able to host such events, and revenue will be reduced by $600,000 each year as a result. 4. The center has already spent $400,000 researching demand for new seating. 5. You have just discovered that a new salesperson will be hired if the center goes ahead with the expansion. This person will be responsible for sales and service of the four new luxury boxes and will be paid $75,000 per year, including salary and benefits. The $75,000 is not included in the 60 percent figure for operating expenses that was previously mentioned. What impact will these requirements and costs have on the FCFs for the project? Exhibit 11.4 shows their impact on the FCFs and NPV presented in Exhibit The 5 percent assessment sounds like an allocated overhead cost. To the extent that this assessment does not reflect an actual increase in cash costs, it should not be included. It is not relevant to the project. The analysis should include only cash flows. 2. The impact of the expansion on the operating profits of the cinema is an example of how a project can erode or cannibalize business in another part of a firm. The $500,000 reduction in EBIT is relevant and should be included in the analysis. 3. The loss of the ability to use the exhibits area, the next best alternative to the new seating plan, represents a $600,000 opportunity cost. The center is giving up revenue from guest lecturers that require exhibit space in order to build the additional seating. This opportunity cost will be partially offset by elimination of the operating expenses associated with the guest lectures. 4. The $400,000 for research has already been spent. The decision of whether to accept or reject the project will not alter the amount spent for this research. This is a sunk cost that should not be included in the analysis. EXHIBIT 11.4 Adjusted FCF Calculations and NPV for the Performing Arts Center Project The adjustments described in the text result in changes in the FCF calculations and a different NPV for the performing arts center project. Year 0 Years 1 to 9 Year 10 Revenue $13,500,000 $13,500,000 Op Ex 8,100,000 8,100,000 New salesperson s salary 75,000 75,000 Lost cinema EBIT 500, ,000 EBITDA $ 4,825,000 $ 4,825,000 D&A 1,000,000 1,000,000 EBIT $ 3,825,000 $ 3,825,000 (1 t) NOPAT $ 2,677,500 $ 2,677,500 D&A 1,000,000 1,000,000 CF Opns $ 3,677,500 $ 3,677,500 Cap Exp $10,000, Add WC 1,000, ,000,000 FCF $11,000,000 $ 3,677,500 $ 4,677,500 10% $11,982,189

13 11.2 Estimating Cash Flows in Practice The $75,000 annual salary for the new salesperson is an incremental cost that should be included in the analysis. Even though the marketing department is a corporate overhead department, in this case the salesperson must be hired specifically because of the new project. The specific changes in the analysis from Exhibit 11.3 to 11.4 are as follows. Revenue and Op Ex after year 0 have been reduced from $14,100,000 and $8,460,000, respectively, in Exhibit 11.3 to $13,500,000 and $8,100,000, respectively, in Exhibit These changes reflect the $600,000 loss of revenues and the reduction in costs (60 percent of revenue) associated with the loss of the ability to host guest lectures. The $75,000 expense for the new salesperson s salary and the $500,000 reduction in the EBIT of the cinema are then subtracted from Revenue, along with Op Ex. These changes result in EBITDA of $4,825,000 in Exhibit 11.4, compared with EBITDA of $5,640,000 in Exhibit The net result is a reduction in the project NPV from $15,487,664 (in Exhibit 11.3) to $11,982,189 (in Exhibit 11.4). Using the General Rules for FCF Calculations PROBLEM: You have owned and operated a pizza parlor for several years. The space that you lease for your pizza parlor is considerably larger than the space you need. To more efficiently utilize this space, you are considering subdividing it and opening a hamburger joint. You know that your analysis should consider the overall impact of the hamburger project on the total cash flows of your business, but beyond estimating revenues and costs from hamburger-related sales and the investment required to get the hamburger business started, you are unsure what else you should consider. Based on the five general rules for incremental after-tax cash flow calculations, what other factors should you consider? APPROACH: Careful consideration of each of the five rules provides insights concerning the other factors that should be considered. SOLUTION: Rule 1 suggests that you should only consider the incremental impact of the hamburger stand on actual overhead expenses, such as the cost of additional accounting support. Rule 2 indicates that you should consider the potential for the hamburger business to take sales away from (or cannibalize) the pizza business. Rule 3 suggests that you should carefully consider the opportunity cost associated with the excess space or any excess equipment that might be used for the hamburger business. If you could lease the extra space to someone else, for example, then the amount that you could receive by doing so is an opportunity cost and should be included in the analysis. Similarly, the price for which any excess equipment could be sold represents an opportunity cost. Rule 4 simply reminds you to consider cash flows from this point forward only. Forget sunk costs. Finally, Rule 5 tells you not to forget to account for the impact of taxes in your cash flow calculations. APPLICATION 11.1 LEARNING BY DOING Nominal versus Real Cash Flows In addition to following the five rules for incremental after-tax cash flow calculations, it is very important to make sure that all cash flows are stated in either nominal dollars or real dollars not a mixture of the two. The concepts of nominal and real dollars are directly related to the discussion in Chapter 2 that distinguishes between (1) the nominal rate of interest and (2) the real rate of interest. Nominal dollars are the dollars that we typically think of. They represent the actual dollar amounts that we expect a project to generate in the future, without any adjustments. To the extent that there is inflation, the purchasing power of each nominal dollar will decline over time. When prices are going up, a given nominal dollar amount will buy less and less over time. Real dollars represent dollars stated in terms of constant purchasing power. When we forecast in real dollars, the purchasing power of the dollars in one period is equal to the purchasing power of the dollars nominal dollars dollar amounts that are not adjusted for inflation. The purchasing power of a nominal dollar amount depends on when that amount is received real dollars inflation-adjusted dollars; the actual purchasing power of dollars stated in real terms is the same regardless of when

14 54 CHAPTER 11 I Cash Flows and Capital Budgeting To illustrate the difference between nominal and real dollars, let s consider an example. Suppose that the rate of inflation is expected to be 5 percent next year and that you just lent $100 to a friend for one year. If your friend is not paying any interest, the nominal dollar amount you expect to receive in one year is $100. At that time, though, the purchasing power of this $100 is expected to be only $95.24: $100/(1 P e ) $100/1.05 $95.24, where P e is the expected rate of inflation as discussed in Chapter 2. In other words, if inflation is as expected, when your friend repays the $100, it will buy only what $95.24 would buy today. You will have earned a real return of ($95.24 $100)/$ , or 4.76 percent, on this loan. Another way of thinking about this loan is that your friend is expected to repay you with dollars having a real value of only $ To understand the importance of making sure that all cash flows are stated in either nominal dollars or real dollars, it is useful to write the cost of capital (k) from Chapter 10 as: 1 k 11 P e 2 11 r2 (11.3) In Equation 11.3, k is the nominal cost of capital that is normally used to discount cash flows and r is the real cost of capital. 2 This equation tells us that the nominal cost of capital equals the real cost of capital, adjusted for the expected rate of inflation. This means that whenever we discount a cash flow using the nominal cost of capital, the discount rate we are using reflects both the expected rate of inflation (P e ) and a real return (r). If, on the one hand, we discounted a real cash flow using the nominal cost of capital, we would be overcompensating for expected inflation in the discounting process. On the other hand, if we discounted a nominal cash flow using the real cost of capital (r), we would be undercompensating for expected inflation. In capital budgeting, we normally forecast cash flows in nominal dollars and discount them using the nominal cost of capital. 3 As an alternative, we can state the cash flows in real terms and discount them using the real cost of capital. This alternative calculation will give us exactly the same NPV. To see this, consider a project that will require an investment of $50,000 in year 0 and will produce FCFs of $20,000 a year in years 1 through 4. With a 15 percent nominal cost of capital, the NPV for this project is: NPV FCF 0 FCF 1 1 k FCF 2 11 k2 2 FCF 3 11 k2 3 FCF 4 11 k2 4 $50,000 $20, $20,000 $20,000 $20, $50,000 $17,391 $15,123 $13,150 $11,435 $7,099 Equation 11.3 can be used to calculate the real cost of capital if we recognize that it can be rearranged algebraically as: r 1 k 1 1 P e With a 5 percent expected rate of inflation, the real cost of capital is therefore: r 1 k , or 9.524% 1 P e 1.05 Discounting the nominal cash flows by the rate of inflation tells us that the real cash flows are: Year 0 Year 1 Year 2 Year 3 Year 4 $50,000 $20, $20, $20, $20, $50,000 $19,048 $18,141 17,277 $16,454 2 As discussed in Chapter 2, if we multiply the two terms on the right-hand side of Equation 11.3, we get 1 k 1 P e r P e r. Since the last term in this equation, P e r, is the product of two fractions, it is a very small number and is often ignored in practice. Without this term, Equation 11.3 becomes 1 k 1 P e r or k P e r. 3 Note that when we use the term cost of capital without distinguishing between the nominal or real cost of capital, we are referring to the nominal cost of capital. This is the convention that is used in practice. In this example, we use the terms nominal or real whenever we refer to the cost of capital for clarity. In the rest of this book, however, we follow